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Adobe Cruising In The Cloud Despite Turbulence

Since 1982, when Adobe was founded in San Jose, Calif,. its design and publishing tools were sold as boxed software at retail or under perpetual licensing agreements. In 1989, Adobe introduced Photoshop which dominates the market for graphics editing. In 2005, Adobe acquired Macromedia whose popular products were Dreamweaver for Web development and Flash.

In May of this year, Adobe caused a stir among its customer base by ending perpetual licensing and offering its products mostly as software as service under subscription plans coupled with a move to the cloud.

There are several advantages of the software as service model for the company. First, it provides a more predictable revenue stream. Second, if the company can hold on to its customers, it increases revenues because customers are always forced to use the newest version.

Under the old perpetual licensing model, many customers did not update to newer versions if they did not need the new features. Further, the subscription model facilitates bundling of less popular products with more popular products such as Photoshop.

This was a highly risky move on the part of Adobe because many users did not like it. For many users this was a significant cost increase. A survey by CNET and Jefferies showed that 76% of CS6 customers did not plan to subscribe to the new subscription model. CS6 refers to the Creative Suite 6 that bundles Photoshop, Illustrator, InDesign, Dreamweaver, Flash Professional, Fireworks, Acrobat X Pro, Bridge, and Media Encoder. Previous spat with AppleApple over Flash added to the risk. Steve Jobs had refused to support Flash, then dominant on the Web, in its new products.

After the market close on Tuesday, Adobe announced its quarterly results. As soon as the earnings hit the wires, the stock dropped about 5% only to jump later about 13% from the low. It’s up nearly 6% today. The initial drop in the stock price was due to Adobe reporting EPS of $0.32 for Q3 compared to consensus analysts’ estimate of $0.34; the company reported revenue of $995.1 million compared to the consensus of $1.10 billion.

Earnings and projections were much worse than expectations but the market chose to ignore them and focus on the company’s success in the cloud. “We exceeded one million subscriptions during Q3, demonstrating that the transition to Creative Cloud is happening sooner than expected,” said Shantanu Narayen, president and CEO, Adobe.

Of note is that in Q3, Creative Cloud subscriptions increased by 331,000 quarter over quarter compared to analysts’ consensus of 262,000.

If the trend in subscription numbers continues, it shows that the uproar among Adobe user base over the change in licensing was simply noise and alternative products are not gaining share as rapidly as would have appeared on the surface.

In spite of the signs of initial success and optimism surrounding the stock, as evidenced by positive comments by Deutsche BankDeutsche Bank, JMP Securities, and Pacific Crest, caution is warranted.

The opportunity is ripe for emergence of strong competition that can benefit from the resentment against Adobe. Investors need to take this into account. On the other hand, if speculative juices start flowing, and Adobe is perceived similar to cloud companies such as Salesforce.comSalesforce.com, Adobe stock can fly. Salesforce.com is a very expensive stock that trades at 8.6 times sales. Adobe is more modestly priced at 5.7 times sales.

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